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I love re-reading the investment classics. One Up On Wall Street, by Peter Lynch, is one of them. On the back cover of the book, it reads: “…You can discover potentially successful companies before professional analysts do. This jump on the experts is what produces ‘tenbaggers’, the stocks that appreciate tenfold or more and turn an average stock portfolio into a star performer.”
And who doesn’t want to find tenbaggers? A couple of tenbaggers in your portfolio can help you beat the market year over year. I’ve been fortunate to invest in stocks that have appreciated tenfold (i.e., $1,000 turns into $10,000), but I’m always looking for more. When I interviewed Canada’s Top Growth Investors (Jason Donville, Martin Braun, Peter Hodson, Martin Ferguson, and Ryaz Shariff) for my book, Market Masters, I learned from them how they went about discovering tenbaggers. The common lessons were: small/mid-cap stocks, low prices, low/ or no dividend, knowledge-based industries (e.g. technology), new products/services, intelligent capital allocators, high rate of growth in book value per share, earnings, and cash flow, etc. As an example, Jason Donville’s investment in Constellation Software is a 30-bagger! (i.e., $1,000 turns into $30,000). There’s more examples in my book.
But back to Peter Lynch – he ran the Magellan fund at Fidelity from 1977 until 1990. And his compounded annual return during those 13 years was 29.2%. Remarkably, during his tenure at Fidelity, Lynch bought more than a hundred “tenbagger” stocks, including Fannie Mae, Ford Motor, Philip Morris International, Taco Bell, Dunkin’ Donuts, L’Eggs, and General Electric. But just how did Peter Lynch find those tenbaggers? He offers some hints in his book, One Up On Wall Street:
“These are among my favorite investments: small, aggressive new enterprises that grow at 20 to 25 percent a year. If you choose wisely, this is the land of the 10- to 40-baggers, and even the 200-baggers…. A fast-growing company doesn’t necessarily have to belong to a fast-growing industry. All it needs is the room to expand within a slow growing industry.” (p.108)
“The best place to begin looking for the [fast grower] is close to home — if not in the backyard, then down at the shopping mall and, especially, wherever you happen to work.” (p.83)
“There’s plenty of risk in fast growers, especially in the younger companies that tend to be overzealous and under financed. When an under financed company has headaches, it usually ends up in Chapter 11…. I look for the ones that have good balance sheets and are making substantial profits.” (p.109)
“There are three phases to a growth company’s life: the start-up phase, during which it works out the kinks in the basic business; the rapid expansion phase, during which it moves into new markets; and the mature phase, also known as the saturation phase, when it begins to prepare for the fact that there’s no easy way to continue to expand. Each of these phases may last several years. The first phase is the riskiest for the investor, because the success of the enterprise isn’t yet established. The second phase [i.e., rapid expansion phase] is the safest, and also where the most money is made, because the company is growing simply by duplicating its successful formula. The third phase is the most problematic, because the company runs into its limitations. Other ways must be found to increase earnings. As you periodically recheck the stock, you’ll want to determine whether the company seems to be moving from one phase into another.” (p.223-4)
“Selling an outstanding fast grower because its stock seems slightly overpriced is a losing technique.” (p.293)
“Wall Street does not look kindly on fast growers that run out of stamina and turn into slow growers, and when that happens, the stocks are beaten down accordingly…. The trick is figuring out when they’ll stop growing, and how much to pay for the growth.” (p. 109)
That last point, “how much to pay for the growth“, is an important one. Peter Lynch suggested a method to judge the price for growth: Price/Earnings to Growth Ratio (PEG). Lynch said: “the P/E ratio of any company that’s fairly priced will equal its growth rate”.
Here’s how to calculate the PEG Ratio:
Acorrding to Lynch, a lower PEG ratio is “better” (cheaper) and a higher ratio is “worse” (expensive). And a fairly valued company would have a PEG equal to 1.
While Lynch popularized ‘tenbaggers’, publicly explaining his methods to find them, there’s two other notable investors who shared their insights: Philip Fisher and William O’Neil. I’ve included their ‘growth investing criteria’ below:
Philip Fisher: The 15 Points to Look for in a Common Stock
1) Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years?
2) Does the management have a determination to continue to develop products or processes that will still further increase total sales potential when the growth potential of currently attractive product lines have largely been exploited?
3) How effective are the company’s research and development efforts in relation to its size?
4) Does the company have an above-average sales organization?
5) Does the company have a worthwhile profit margin?
6) What is the company doing to maintain or improve profit margins?
7) Does the company have outstanding labor and personnel relations?
8) Does the company have outstanding executive relations?
9) Does the company have depth to its management?
10) How good are the company’s cost analysis and accounting controls?
11) Are there other aspects of the business somewhat peculiar to the industry involved that will give the investor important clues as to how the company will be in relation to its competition?
12) Does the company have a short-range or long-range outlook in regard to profits?
13) In the foreseeable future, will the growth of the company require sufficient financing so that the large number of shares then outstanding will largely cancel existing shareholders’ benefit from this anticipated growth?
14) Does the management talk freely to investors about its affairs when things are going well and “clam up” when troubles or disappointments occur?
15) Does the company have a management of unquestioned integrity?
Source: Common Stocks and Uncommon Profits. Philip Fisher.
William O’Neil: CAN SLIM® System
“C stands for Current earnings. Per share, current earnings should be up to 25%. Additionally, if earnings are accelerating in recent quarters, this is a positive prognostic sign.
A stands for Annual earnings, which should be up 25% or more in each of the last three years. Annual returns on equity should be 17% or more.
N stands for New product or service, which refers to the idea that a company should have a new basic idea that fuels the earnings growth seen in the first two parts of the mnemonic. This product is what allows the stock to emerge from a proper chart pattern of its past earnings to allow it to continue to grow and achieve a new high for pricing. A notable example of this is Apple Computer’s iPod.
S stands for Supply and demand. An index of a stock’s demand can be seen by the trading volume of the stock, particularly during price increases.
L stands for Leader. O’Neil suggests buying “the leading stock in a leading industry”. This somewhat qualitative measurement can be more objectively measured by the Relative Price Strength Rating (RPSR) of the stock, an index designed to measure the price of stock over the past 12 months in comparison to the rest of the market based on the S&P 500 or the TSX 300 over a set period of time.
I stands for Institutional sponsorship, which refers to the ownership of the stock by mutual funds, particularly in recent quarters. A quantitative measure here is the Accumulation/Distribution Rating, which is a gauge of mutual fund activity in a particular stock.
M stands for Market Direction, which is categorized into three – Market in Confirmed Uptrend, Market Uptrend Under Pressure, and Market in Correction. The S&P 500 and NASDAQ are studied to determine the market direction. During the time of investment, O’Neil prefers investing during times of definite uptrends of these indexes, as three out of four stocks tend to follow the general market pattern.”
Robin Speziale is the national bestselling author of Market Masters, which is available at Chapters, Indigo, and Coles as well as Costco and Amazon.ca. He lives in Toronto, Ontario. Learn more about Market Masters.
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